I believe stockmarkets are far from efficient. Correctly valuing a business is an extremely difficult problem that both requires investors to predict the future and is lacking in clear sensible benchmarks. It is unsurprising that investors systematically and collectively get this wrong in various ways. Markets are also affected by emotional swings, information problems and liquidity issues. The result is that many shares are mispriced and often dramatically so.
There are many strategies to exploit these systematic mispricings and ‘beat the market.’ However, they are not straightforward to define and implement. This is partly because it is difficult to generate sufficient evidence to really know whether a strategy would outperform in the long term – ‘is my strategy doing well or am I just being lucky?’ On one hand this makes things very difficult, but on the other hand it makes it easier for bad strategies and mispricings to persist, leaving more to play for.
My strategy is focused primarily on exploiting two particular factors in combination: a) the tendency for high quality defensive businesses to outperform over time and b) the tendency of shares with momentum to continue to do well.
So how have I arrived at this? My main source of inspiration is all the empirical evidence supporting ‘factor investing’. This is the idea that shares with certain qualities (e.g. value, quality, momentum, small caps) are statistically more likely to outperform the market over the long term. Over the past few years I have followed the outperformance of the ‘Stockranks’ developed on Stockopedia with great interest. My other inspiration is Warren Buffett, who demonstrated that you could get phenominal returns from investing in high quality defensive shares over the long term. In the UK I have drawn from the approaches of Terry Smith and Nick Train, who follow in this tradition.
There is empirical evidence that factors work better in combination with one another. Intuitively this makes sense. Factors are not mutually exclusive and each exploits a different behavioural bias. It is difficult to think about the ‘value’ of a share in isolation from its ‘quality’ – the two are part of a bigger whole. How best to combine factors is a challenge of limitless complexity. Stockopedia’s Stockranks suggest that a simple weighted index can work very well, but I see this as a starting point rather than the only or best approach.
The backbone of my approach is to first consider the long term quality of a share independently of its current price. I screen out all potential investments unless they are of very high quality. I then decide which of these high quality businesses to invest in at any given time on the basis of their current pricing, taking account of price momentum and to a lesser extent valuation. To me this structure of choosing investments makes better intuitive sense than applying all factors simultaneously. Quality is a more long term concept. While momentum and value are functions of the share price, quality is not.
‘Quality’ is a broad concept and hard to define or measure. In principle, it is determined by how much profit a business is likely to make over its whole lifetime. Luckily to do well you don’t need to predict this in an absolute sense, but can more simply identify which businesses are higher quality than others. This is possible with the easier question ‘does the business possess characteristics which make it more likely than other businesses to grow profits over the long term?’
In practice, quality factors are metrics that can range from measures of a business’s balance sheet strength, its historic ability to generate and profitably reinvest cash to the quality of its management. Some of these factors are predictive of future profitability. They are often not of much value in isolation, but need to be looked at collectively within a sensible framework.
Qualitative assessment is an important supplement to looking at metrics. Assessing quality is basically attempting to predict the future. To do this you need to have a view about things like whether a company has a competitive advantage that will endure and whether it is in a defensive, growing market.
Why the highest quality is undervalued
One reason that quality is undervalued is that it can be difficult to measure. Identifying quality requires some qualitative judgment of points that are harder to measure (e.g. how much of a competitive advantage does a business have) and people often prefer to focus on what they can measure.
A more important reason is that the market is myopic and underestimates the importance of compound growth in profits over the long term. To assess the valuation of a business properly, you need to incorporate the compounding of future growth into the valuation.
Traditional valuation measures, like the Price Earnings ratio, don’t do this. A share’s worth is determined by what will happen to profits in the future, while these valuation measures look only to the past. They treat a business with low costs and a highly valued product protected by IP the same as a business in a highly competitive market that is having to reinvest all of its profits just to stay afloat.
Despite this, many investors heavily base their decisions on metrics like the PE ratio without explicitly accounting for future growth. They face the pitfall that this tends to lead them to a truncated mental ‘rule of thumb’ valuation model, e.g. where anything with a PE of above 20 is ‘expensive’ and anything with a PE of around 10 is ‘cheap’. However, the range of ‘fair value’ PE ratios that you get if you properly take into account differences in likely future compound growth across different businesses is much larger than this. A business able to consistently reinvest its profits into growth steadily over time should often be fairly valued at several multiples of the PE ratio of a cyclical business where sustained compound growth is much less likely. The importance of this only becomes evident when you take a very long term perspective, which most do not.
As a result, in most cases the highest quality businesses will trade on higher PE ratios relative to average businesses and so appear expensive. However, they can often be astoundingly cheap despite of this when you more carefully consider their likely profitability over the very long term.
The fundamental reason that there is such a broad range in ‘fair’ valuation multiples is that the highest quality businesses possess unique characteristics which will allow them to sustainably earn high profits and grow without needing to invest huge amounts. Average businesses will only at best be able to do so for shorter periods before competition is attracted or the business cycle turns. In the very long term, returns in the stock market are very unevenly distributed across businesses, with a small minority of high quality businesses taking the lion’s share. Quality investing is essentially about identifying these businesses.
This is the rationale for one of the key features of my approach – that I focus much more closely on identifying high quality than on thinking about valuation. I do this not because I think valuation is unimportant but because I believe the market is biased the other way.
Momentum fits well
The other complementary aspect of my strategy is to exploit share price momentum. In terms of factor investing I think momentum is the closest thing there is to a free lunch. The existence of significant excess returns to momentum has been demonstrated consistently across markets and time. Despite this, many investors dismiss the idea of trend following and prefer to only look at fundamental valuations. More fool them – this allows the effect to persist. Momentum is real and arises for a large number of compelling reasons to do with the underlying performance and characteristics of the business, investor behavioural biases, information issues and liquidity. Surprisingly, it can often be a good indicator that a share is undervalued. See my post on momentum to see why.
Momentum is easy to observe and to implement into a strategy so is a powerful tool in practice. Exploiting momentum involves buying shares that are rising in price and especially just after issuing positive news, or selling shares that are falling in price and especially just after issuing negative news. Run winners and sell losers! I think you’re missing a trick if you are a private investor who doesn’t incorporate momentum into your investing strategy in some form – the ability to exploit momentum well is one of the big advantages small investors have over larger institutions who suffer from holding large illiquid positions.
Exploiting momentum also is complementary to focussing on very high quality shares as these should tend to exhibit more consistently rising prices over the longer term. Momentum, particularly over the longer term, can therefore be a useful indicator of quality in conjunction with other factors.
Another benefit of exploiting momentum is that it provides the discipline to deal with mistakes effectively. Identifying quality is hard. The only thing certain about the future is that I can’t predict it with certainty, so I want to have a strategy that is going to miminise losses from mistakes rather than lead me to anxiety and poor decision making. I really don’t want to experience the ‘value investor’s headache’ – ‘is the share price falling a good thing that means I should buy more or the sign of a terrible mistake?’ While counter-momentum or ‘mean reversion’ / value type strategies can be sound in principle, one of their major weaknesses is that they require much more conviction than momentum following.